Downhole Navigator, L.L.C. v. Nautilus Ins. Co., No. 4:10-0695 (S.D. Tex. May 9, 2011)
The bargain universally made between the policyholder and the liability insurer is that insurer promises to defend and indemnify the policyholder against all the risks of legal liability alleged in the lawsuit, and in return, the insurer has the right to call the shots on the best way to defend the lawsuit, including the right to select the defense attorney. However, that right to control the defense may shift if the lawsuit alleges one or more claims that the insurer believes are not covered by the insurance policy, and the insurer notifies the policyholder that the insurer is defending subject to its right to deny coverage for this, that, and the other uncovered claim. The "reservation of rights" letter, which the insurer is required to send to preserve its coverage defenses, may put the policyholder in the driver's seat if (and this is the big if illustrated by this case) the insurer's reservation of rights creates a "conflict of interest" between the insurer and the policyholder.
This shift of control of the defense became a fixture of Texas law in North County Mut. Ins. Co. v. Davalos, 140 S.W.3d 685, 688 (Tex. 2004). The Texas Supreme Court held that a conflict of interest created by a reservation of rights letter would shift to the policyholder the right to select defense counsel on the insurer's nickle. However, the Court said that, if an insured rejects the insurer's defense without a sufficient conflict, the insured loses the right to recover defense costs. So what constitutes a "sufficent conflict"?
The test is deceptively simple. "[W]hen the facts to be adjudicated in the liability lawsuit are the same facts upon which coverage depends, the conflict of interest will prevent the insurer from conducting the defense." Id.at 689. A example of this is the lawsuit alleging that John Doe either was negligent when he smashed into his neighbor's tree, or he did it on purpose because he had a heated argument with the neighbor an hour before the accident. The neighbor bringing the lawsuit is probably hedging his bets. It's easier to prove negligence, but he has a shot at even more damages if he can convince a jury that the act was intentional. However, the defendant's insurance policy covers negligence but not deliberate acts. Presumably, the insurer will send a reservation of rights letter, explaining to the insured that it will defend the lawsuit because negligence is alleged, but the insurer will not pay any damages should the jury find the damage was intentional.
This letter creates a conflict of interest because the facts to be adjudicated at trial (did he act with intent or negligence?) are the same that determine coverage or not. Unpacking this a little, the core concern is that the attorney hired by the insurer, who probably depends on the goodwill of insurance companies for her daily bread, might work against the defendant's best interests and, ever so slightly, nudge the development of the case to highlight the heated argument and benefit the insurer.
In the Downhole case, an oil drilling company was sued after it allegedly "slacked off" over the drill and caused various forms of damage:
including. but not limited to: loss of profit; loss of business opportunity; loss of investment opportunity; loss of value of lease; loss of minerals; cost of delay in performance, anticipated remedial costs and other damages.
The driller sought defense and indemnity, and Nautilus sent a reservation of rights letter, which stated:
Nautilus Insurance company will provide your company wit a defense to these claims. However,Nautilus reserves all rights to disclaim any duty to indemnify for claims and judgments which fail to seek "damages" under the policy, as further set forth below.
The policy covers only "property damage," defined as physical injury to tangible property. The lawsuit alleged a host of damages that are not "property damage," such as delay damages, loss of investment, and other non-tangible economic losses. Yet the lawsuit at least potentially alleges physical injury to the well itself. So, did the reservation of rights create a conflict of interest?
The magistrate judge said no. "The question for the court, then is whether the 'facts to be adjudicated' in the lawsuit are the 'same facts upon which coverage depends." The court then reasoned that, because the lawsuit alleged that the driller was negligent, that is not an issue upon which coverage depends. The court was using as its yardstick a case called Housing Authority of Dallas v. Northland Ins. Co., 333 F. Supp.2d 595, 601 (N.D. Tex. 2004), in which the coverage determnation turned on whether the alleged wrongful conduct was willful or not. The magistrate judge in the Downhole case concluded that Northland did not apply since willfulness was not alleged.
But that misses the point. The conflict of interest frequently arises from alternative allegations of negligent and willful conduct, but that is not the only issue that can create the conflict. In this case the driller argued that the conflict resided in the alternative forms of damage, some of which were not covered. So a defense lawyer hired by the insurer could nudge the development of the case in such a way as to emphasize the uncovered damages or to fail to develop any evidence of physical damage to the well. And voila, the jury awards nothing but intangible losses that the insurer happily refuses to pay. How is that not a conflict of interest?
The district court judge might want to review this one.
David S. White, Thompson & Knight LLP